Summary
FedEx reports on June 19th, providing the first major data point for our thesis. For FY4Q 2013, expect a terrible looking headline number, since charges for buyouts and accelerated depreciation are expected in the quarter. That should not matter and we are instead looking for three significant items:
- Express Margin: We expect to see meaningful sequential margin improvement at FedEx Express from the low bar set in FY3Q. This is a key “show me” item and necessary evidence for our valuation and thesis.
- Fleet Update: A new fleet replacement schedule, which should show how Express will manage accelerated retirements.
- Guidance: FY14 guidance, which we expect to look something like $7.00-$7.50.
We think FDX is a show me stock. Investors may see the opportunity, but the company needs to deliver margin expansion in FedEx Express for buy-in. In terms of timing, it did not help to have the Investor Meeting and get the market excited about the prospects for margin expansion, while at the same time not expecting to deliver any visible benefits until FY 4Q 2013 (the quarter they report on June 19th). The FY 3Q disappointment does set a low bar, in our view. As long as FDX shows decent margin improvement sequentially, and a path to further progress in guidance, we expect the shares to regain their pre-FY3Q momentum.
FY2014 Guidance Outlook
FedEx management has told us to expect $1.6 billion in profit improvement at FedEx Express by FY16, with 75% coming by FY15. They have also indicated that those gains are ahead of schedule and should be relatively evenly distributed through time. The improvement is measured from FY13 Express operating income, which we do not know precisely, but should come in around $850 million. That puts FY14 at around $1,450, or a little better given that the cost reductions are ahead of schedule. Assuming FedEx Ground comes in around $1,950 (growth below recent volume growth) and FedEx Freight at about $300 million, one gets ~$7.30-$7.40 for FY14 EPS at a 36% tax rate. So the current implied guidance matches current Bloomberg consensus of $7.35.
Last June, FDX guided to a $6.90-$7.40 for FY13, which it will miss with a number closer to an adjusted $6.00-$6.15. Last year, FY13 consensus estimates were about where they are now (~$7.35) for FY14. Expectations this time do not appear out of line with what is achievable and what the company has communicated. While the range may leave some downside wiggle room, we do not expect guidance that does not include consensus within its bounds. A decent guess for the range is probably $7.00-$7.50. Given the expectations implied by recent share price performance and investor skepticism, that range will probably be interpreted favorably.
2014 Specifics
Looking at the specifics around the FY14 guidance expectations, we highlight some of the key differentials vs. a challenging FY13.
Postal Contract vs. Pension
The new USPS contract lowers pricing by about $100 mil and adds some volume, a headwind likely to be in the range of $100-150 million. However, in FY13, FDX saw “a historically low discount rate at our May 31, 2012 measurement date … increase these [Pension] costs by approximately $150 million.” The recent sell off in bonds, in addition to favorable equity market performance, is likely to have a favorable effect on FY14 pension expense. While difficult to calculate precisely, we estimate that the pension improvement should largely offset the negative impact from the new postal service contract.
International Express & Aircraft Reallocation/Retirements
In recent quarters (particularly FY3Q), FDX has had too much low yielding Deferred volume in its high cost International Priority line haul. Weak international trade has also left many channels unbalanced – i.e. full planes out, part empty ones back. Both of these factors hurt profitability in what is typically one of FedEx Express’s highest margin product categories.
The solution FDX began implementing April 1 was to shift the Deferred volume to the belly space of commercial aircraft. This has three key benefits. First, capacity can be removed while maintaining service. Second, the partially empty flight back can be eliminated since the commercial aircraft space can be one way. Finally, the excess aircraft capacity freed can be reallocated to the U.S. express market. FedEx has its most efficient aircraft in the international express market, so reducing capacity in international express has permitted those more efficient aircraft to swap out high cost domestic aircraft.
The net impact of these changes is substantial, consisting of higher utilization, better network balance, earlier aircraft retirement and potentially better pricing. While one fewer Asia route probably saves an annualized ~$100 million in fuel and a bit more in related costs, there are follow-on impacts from aircraft reallocation. The early retirement of the 727 fleet, A310s, MD10s already announced likely add an additional $75-125 million. Additional aircraft retirements during FY14 should also contribute, as may the impact of better network balance and capacity. Aircraft retired during FY12 should also help the comp. Ping us back if you want more specifics, but on balance, we think these factors should contribute $300-$400 million relative to FY13.
Headcount Reduction
While FDX has yet to disclose how many employees have taken the voluntary buyout offer, we estimate that it is likely to impact 3%-4% of headcount. Assuming the reductions are straight-lined through the year, the lower headcount and administrative should favorably impact costs by ~$150-$200 million.
Squishier Items & Fuel
DHL had great success with harder to specify profit improvement efforts in areas like at IT and sales. While much of the FedEx restructuring is more specific, items, like “yield management” can be harder to quantify. Fuel prices also appear to be lower for FY14 and FDX guides assuming stable fuel prices, providing a small benefit relative to lagged surcharges. On balance, the benefit from this category readily makes up the balance for FedEx Express’s $600 million in profit improvement.
International Trade Down vs. Volume Growth
If FY 3Q 2013 international IP vs. Deferred trends persist during FY14, that would create a sequential headwind. At the moment, there doesn’t seem to be much reason to expect the trade down to reverse, but there rarely is. The increased use of commercial lift should help offset the impact. Further, the domestic express market appears to be improving and the negative mix shift may end up offset by volume growth, which has been less of a focus for investors.
Ground Assumption
The difficult comp in FY3Q 2013 for FedEx Ground (vs. a previously not highlighted insurance reserve reversal) may have lowered the expectations for this segment. Improving U.S. economic activity, particularly on the consumer side, could create profit growth in line with volume growth – a favorable variance relative to our expectations.
Upshot: FedEx is likely to guide FY14 in line with what it has already hinted. We see the guidance as attainable now that it is the management focus. For the quarter, we expect the sequential trends in Express to be the most relevant to our thesis and valuation.
